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Graham Bentley: How advisers can meet their duty to consider structured products

The industry has an obligation to take a fresh look at this space, but due diligence remains critical

Last month, I suggested there may be a real opportunity for structured product providers to compete in the absolute return space if advisers could be persuaded to be open-minded enough to embrace well-constructed solutions.

It does seem some advisers’ minds are firmly closed on this issue. Indeed, since my article, I have been deemed an “idiot” by at least one adviser, while others scoffed at my apparent advocacy of them as a panacea for fund management ills.

One typically anti-everything (bar trackers) commentator even evoked the spirit of Pete Seeger, wailing “when will they ever learn?”.

Let’s first dispense with the common tarring of structured products as toxic, referencing their prevalence in the commission-bearing offshore market or the precipice bond debacle.

These protestations are irrelevant. In the UK, commissions cannot be incorporated into the pricing model.

As for precipice bonds, much of that furore was down to misselling – mostly by a small number of greedy retail banks desperately trying to raise alternative capital, and who were punished accordingly.

My “well-constructed” definition adheres to the FCA’s recommendations in TR15/2, the thematic review of structured products published in 2015.

The products should provide clear economic value to a defined target market of customers, via pay-off profiles that are attractive but not extreme, having been stress-tested accordingly. Their objectives must be fair and clearly articulated, with marketing material allowing advisers to ensure any product is suitable for their clients, who in turn match the target market.

In other words, the definition applies to structured products in exactly the same way as it does with any other financial product.

Solutions properly designed by the strongest providers for retail investors but distributed by advisers are almost, by definition, unlikely to become future industry bêtes noires.

Structured products should be seriously considered by diligent advisers, and adequate research performed, rather than a lazy or stereotypical dismissal. As with any intermediated investment opportunity, individual client suitability is not assessed by the provider but by the adviser.

Since a structured product is no more than a contract between the investor and the provider to fulfil an objective if a certain set of criteria are met (or indeed avoided), it is, in essence, a bond – the stronger the issuer, the less likely a default.

Bond issuers price in perceived default risk via higher coupons. Pay-offs in structured products may not similarly reflect counterparty risk, so this is the most fundamental risk that needs to be assessed by the intermediary.

I suspect a significant number of advisers are rather less confident assessing counterparty risk, or the risk/return profile and “value for money”, of a structured product than of a fund or portfolio.

Banks’ credit ratings might be an obvious starting point, but the regulator is quite specific that, in isolation, this is insufficient data upon which to assess counterparty quality, as became apparent in the financial crisis of 2008.

Credit default swaps are an additional important indicator of counterparty risk. Effectively an insurance contract covering the potential non-payment of a debt, the buyer of a credit default swap receives credit protection, while the seller guarantees the creditworthiness of the issuer. The changing spread on the swap (i.e. its price) reflects the perceived creditworthiness of the issuer in real time.

Assessment of risk requires both backward and forward-looking metrics, as per fund research.

Credit ratings are forward-looking views, balance sheet fundamentals are historical “facts” as at the date of the last set of published reports and accounts, while past volatility of CDS or share price are backward-looking indicators.

However, while advisers might use FE or Morningstar data and analysis tools to produce “scorecards” by which to screen funds on a quantitative basis, they may have less knowledge about sources of information and data analysis on structured products and providers. The FT Banker Database identifies approximately 3,400 banks globally. A useful rule of thumb might be to restrict the due diligence process to global systemically important banks or, as a minimum, domestic systemically important banks.

As the name suggests, GSIBs are the more important banking groups globally and, as a result, are subject to higher supervisory expectations on risk management, governance and capital adequacy requirements.

The latter includes higher Tier 1 capital ratios, along with further incoming rules regarding total loss absorbency capacity. But this data does not easily come to hand.

As for assessment of a product’s “economic value”, there are a variety of less familiar metrics that cover return potential; e.g. expected return to value at risk best 10 per cent ratio – the higher the number, the greater the likelihood the headline return will be achieved and lower the risk of the investor misinterpreting potential returns.

Businesses like Tempo Structured Products and Levendi Capital provide comprehensive scorecards, respectively for issuer and counterparty risk, and product risk/return analysis. Tempo offers comprehensive training modules within its adviser academy, and is the first structured product provider to be both a corporate member of the Plain English Campaign and to have all its marketing material Crystal Mark approved.

The industry is increasingly challenged to provide solutions that are economically appealing to retail investors. Structured product providers whose solutions are aligned to customer and regulator expectations can be an important contributor to investor wellbeing.

But that depends on advisers accepting they have an obligation to take a fresh look at today’s structured products landscape and investigate those opportunities diligently.

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21st January 20193:05 pm

Comments

There are 12 comments at the moment, we would love to hear your opinion too.

Thank you Graham. A very objective and hopefully thought provoking article for professional advisers.

As you say, the structured products sector has come a long way, particularly over the last decade. It is now characterised by a far smaller number of better calibre providers, operating within a highly prescriptive regulatory framework of rules and expectations, with better designed, better calibre products used by and aligned with better supported independent professional advisers, who select products on merit, following robust research due diligence, based on suitability.

Importantly, structured products are being used judiciously as part of diversified ad balanced portfolios, by objective professional advisers who recognise that the USP merits of best of breed structured products include attributes and features that neither active nor passive funds can offer, notably including the scope to generate positive returns that do not require markets to rise, while usually also including a defined level of protection if they should fall.

Particularly at this time, when many advisers think that the easy money have been made over the last decade, and that the decade ahead will be a more challenging investment environment in which to generate strong viable levels of return, with good risk / return profiles, the benefits of including structured products in portfolios are being more widely recognised and understood.

I’ve used structured deposits a few times, when the markets were very low (kick out plans) which worked really well but, generally, don’t like fixed term plans that can mature at a very inopportune moment.

Nothing wrong with what has been said in the article though I’m curious as to why such a hard sell? In any event one thing it doesn’t do is acknowledge or explore the downsides.

Firstly, even relatively simple products can be beyond the average investor to understand (and that’s what the FCA think too, see their comments on their website) and if they don’t understand it, it can’t be suitable.

Secondly, are the true costs really transparent? It’s not clear whether the money made by the provider on the underlying instruments is factored in and these can be significant. It might not be a ‘direct’ cost but it’s being funded by someone and that’s the client. Without knowing how the proceeds are being split how do you assess value for money?

Thirdly, like it or not, the regulator doesn’t like them and that should make advisers nervous. I’ve attended seminars where senior FSA/FCA staff have commented and it’s not positive. Two particular comments stick in my mind. SPs were likened to gambling where the provider has all the knowledge and only shares some of it (e.g. who, and to what extent, is carrying the risk in the product compared to the reward?). The other one is more sobering – that SPs were a time bomb waiting to go off, it could be next year, it could be in 10 years, but when it does someone will have to pay. Guess who?

Lastly, if a product doesn’t fall under the FSCS (and even many simple ones don’t – first one I found just now by Googling doesn’t and it’s ‘simple’ and retail targeted…) then chances are the FCA and FOS will see this as similar to UCIS in terms of risk and who should be buying it. Of course, all is well and good until something goes wrong – see above comment.

Whilst never dismissing using a SP on ideological grounds, the above means it gets dismissed pretty quickly for the average client.

MIFID2 regulations require all firms to provide information on the target market that a product is designed for, very much with the aim to ensure that products are not sold to people who cannot understand them (and notably their risks). You will find that, in line with regulations, structured products go through a rigorous product governance framework, that covers various stress testings and target market analysis.

Most structured products are designed for retail investors where advice is being given, allowing the investor an opportunity to discuss any risks that are explained within a brochure of a product with their adviser, prior to making an investment decision. As you say, if an investor does not understand the investment even after such discussions, it is highly unlikely an adviser will recommend it within their portfolio.

Regarding costs, you will be pleased to hear that since the introduction of PRIIPS regulation, that came into force 1st January 2018, you will find ALL costs/margin must be disclosed by the manufacturer on any packaged retail investment (including all structured products) within the new KID document.
You will find this under the “what are the costs” section.

Regarding the regulatory status of structured products, as with other investment types there have been many reviews over the years by the FCA of the structured product industry, both from a manufacturer and advisory perspective. To clarify, structured products fall firmly within the PRIIPS and MIFID2 regulatory framework and are recognised as a packaged retail investment within the UK by the FCA. They are definitely NOT classed as a UCIS (which for clarity for those reading this, cannot be promoted to the general public in the UK).

On the client understanding point, many, if not most, of these products will have a statement in the KID to the effect that they are complex and may be difficult to understand. To my mind that suggests that most retail investors will struggle. Understanding is fundamental to suitability and advisers need to be sure they can pro-actively demonstrate the client understood the investment (when they are swearing blind to the FOS the opposite).

On the costs point I accept these are disclosed in the KID but I’m not convinced they include the margins on the underling derivatives created by the issuer – happy to be given a definitive answer on this…

For clarity, I was not suggesting they are UCIS, I know they are not. My point is that many/most are not covered by the FSCS. Past experience with the FOS suggests that this fact will be seen as a material in deciding whether a product is higher risk and whether it should be recommended to retail clients – I’ve had this point put to me in respect to UCIS so why would this be different?

Structured products can be suitable and have their place, I just don’t think they are an appropriate mass market product.

I was around when things blew up before and the key problem was the way they were marketed. Essentially they were sold as secure products where losing money was either ignored or such a remote possibility it wasn’t really worth contemplating, focus was always on those attractive ‘fixed’ returns. That’s all fine until people start losing money and then the blame game starts and advisers are the front line. You are less likely to be run over if you don’t stand in the road…

If IFAs did some research on the past performance of structured products they would realise that in the vast majority of cases the returns have been fantastic. The plans are covered by the FSCS up to £50,000 in the event of default (but obviously not counterparty failure which is classed as investment loss), and for any money held as cash the deposit compensation scheme applies. “I was around when things blew up,” says ‘Grey Area’. When things blew up it was the banks that failed and the deposit compensation scheme then was only £35,000 with £2,000 at 100% and the rest at 90%. So the taxpayer had to step in to save all those people who had deposited money in high risk investments called bank deposit accounts!

I was referring to the problems with precipice bonds 15-18 years ago not banks. Investors lost money because the contracts didn’t perform as expected, i.e. investors thought they were getting guarantees because they focussed on the headline returns. When the markets didn’t play ball and they lost money the FSA got involved and blamed advisers. It wasn’t pleasant then and it’s a tougher regime for that sort of thing now.

As I said previously, structured products are great when they perform, the problems will come when they don’t. Hence the reference to a time bomb waiting to go off (not my quote).

Why does the literature for most of the products I look at say they are not covered by the FSCS?

I repeat, I think they have their place, I just don’t think it’s in the mass market, that’s my opinion.

Some precipice bonds failed because they only had one check date at the end of the investment term. Clients who claimed they didn’t know the FTSE 100 could go down as well as up and who lost money complained. Since then autocall products have been introduced with numerous check dates in the potential investment term and Sky News have the minute by minute change in the index in the top left corner of the screen. There’s a bond out at the moment for example with Morgan Stanley as counterparty. It requires 5.0% growth in the FTSE 100 index on a check date to yield 12.33% per annum. 5.0% growth from where we are now (7,165.24 as I write) is 7,523.37 which is 4.49% below May 22nd close. This plan has check dates on the second anniversary and every year after that for 10 years! Can you imagine a situation where this fails to produce a positive return because of the poor performance of the index? And if you can, name me one mass market unit trust that would give you your money back if over 10 years the FTSE 100 has never been up by 5.0% on an anniversary and when in 10 years time the FTSE 100 is down by up to 30%. As for the FSCS, if Morgan Stanley fails money could be lost and it’s classed as investment loss and not covered by the scheme. They allowed Lehmans to collapse (Barclays could have saved it with FSA approval) and the world financial system almost collapsed. Do you honestly think they would allow a repeat of that? Finally the plan manager is regulated by the FCA and if clients lose money because of the plan manager’s actions and they are placed in default the FSCS kicks in. The industry has learned a lot since the “precipice bond” misselling saga.

Let’s consider two things here. Firstly, investment companies (especially those creating and packaging derivatives) do not give money away. Secondly, returns in comparison to the risk free rate must reflect the level of risk taken. In light of this, how do you explain the returns offered? Who is taking the risk and what is the payment for this?If advisers can’t explain it then, respectfully, they don’t understand it. If they don’t understand it, how will clients?

There’s no such thing as a free lunch. And when people start making statements like “Can you imagine a situation where this fails to produce a positive return because of the poor performance of the index?”, it starts to sound like they can’t lose, i.e. it’s guaranteed. That was the problem the last time round…

If you don’t know what’s in it for the issuer how can you assess value for money? If you don’t understand where the risk is how can you assess it?

I actually know the answers, do you?

As for your question, that depends on how much of a client’s portfolio is committed to the FTSE 100, it’s level and spread of diversification, etc. I do know they will be in a position to wait things out. In that sort of market, how sure are you that any counterparty will be able to pay what’s promised?

After the collapse of Lehmans, structured products that had used them as a counterparty failed to return clients’ money in full. As far as I am aware, no other counterparty to any other structured plan on the market at the time failed to return clients’ money promised in the plan documentation. However, had it not been for government intervention using taxpayers’ money, tens of thousands of bank customers would have lost their life savings deposits. So which proved to be the highest risk investments? Structured plans or bank deposits?

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